A loophole exists in current law that allows certain wealthy professionals to avoid paying payroll taxes on their earnings, like every other working American has to do. Commonly known as the “Newt Gingrich/John Edwards” loophole, this loophole is used most often by Subchapter S Corporations (“S-corp”) to avoid the Medicare tax on earnings. This costs taxpayers hundreds of millions of dollars every year.

How the Loophole Works

Consultant A is in-house counsel for a small firm. He uses his years of experience and connections to provide his clients with advice on a variety of issues. He is well compensated for his work. Last year he made $1,000,000 as an employee. Because his employer is a C corporation, 100% of his compensation is treated as performance of services and subject to payroll taxes.

Consultant B has gone out on his own as a consultant for hire. He has been successful and earned $1,000,000 last year for his work on behalf of his clients. He has formed his own S-corp of which he is the sole owner. His full salary is passed through to him as wage compensation and he pays self-employment payroll tax rates.

Consultant C has also gone out on his own and been quite successful. He uses his skills and reputation to advise his clients. He has received $1,000,000 in total compensation for services and like Consultant B, he is also incorporated as his own S-corp. However, unlike Consultant B, he found an article on the internet that showed him how he could dodge payroll taxes on most of his service income. He only treats $100,000 of his earnings as wage compensation for performance of services. The other $900,000 is treated as the company’s profits that pass through to him. This allows him to avoid payroll taxes on the other $900,000 he earned. By exploiting this loophole, Consultant C is able to avoid over $26,000 in payroll taxes.

John Edwards: Senator Edwards earned $26.9 million from his work as a trial lawyer in 1995. He paid himself a salary of $360,000 each year for four years and took the rest as distributions from his S corp. This saved Senator Edwards an estimated $600,000 in payroll taxes. [New York Times, 7/10/2004]

The Solution
This proposal closes the Gingrich-Edwards loophole by requiring those with modified adjusted gross income (adjusted gross income increased by the taxpayer’s excludible foreign income and housing cost amount and without factoring the deduction for payroll taxes) over $250,000 to include in income for purposes of payroll taxes any income from a limited partnership interest in a professional services business or a S corp in a professional service business in which more than 75% of its gross revenues come from the service of 3 or fewer shareholders.

This proposal does not raise anyone’s taxes. It closes a loophole that allows wealthy individuals to cheat the system by structuring their businesses to avoid payroll taxes. It does not change what anyone owes. It forces wealthy tax cheats to pay what they already owe.

The proposal is targeted only to those S-corps that derive 75 percent or more of their gross revenues from the services of three or fewer shareholders or where the S-corp is a partner in a professional service business. The proposal also applies to partnerships.

This proposal only applies to S-corps and partnerships in the fields where virtually all of the earnings are attributable to the performance of services. Thus, they should be subject to payroll taxes. These are professional service businesses engaged in the fields of health, lobbying, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, brokerage services, or investment advice or management.

This proposal exempts S-corp shareholders or partners in partnerships with modified adjusted gross incomes below $250,000 for joint filers and $200,000 for individuals.

This proposal prevents professional services income from being mischaracterized to avoid employment taxes. However, legitimate passive income (rents, dividends, interest and certain gains) accrued to the S-corp will continue to be treated as such, and will continue to be exempt from employment taxes.